Section 338(h)(10) Election: An In-Depth Guide for M&A Tax Planning

A Section 338(h)(10) election is a nuanced and powerful provision within the Internal Revenue Code, designed to provide flexibility in the tax treatment of certain corporate acquisitions. Specifically, it allows a stock purchase-normally treated as such for both legal and tax purposes-to be treated as an asset purchase solely for federal income tax purposes. This election, codified at 26 U.S.C. § 338(h)(10), is particularly relevant in transactions involving S corporations or subsidiaries within consolidated groups. The election’s primary advantage is the ability for the buyer to receive a stepped-up basis in the acquired assets, which can yield significant tax savings through enhanced depreciation and amortization deductions. However, the election also carries important consequences for sellers and requires strict compliance with statutory and regulatory requirements.

Legal Background and Statutory Framework

The legal foundation for the Section 338(h)(10) election is found in the Internal Revenue Code at 26 U.S.C. § 338(h)(10), with detailed procedural and substantive rules set forth in Treasury Regulation § 1.338(h)(10)-1. The election emerged as a legislative response to judicial doctrines established in cases such as Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff’d, 187 F.2d 718 (5th Cir. 1951). In that case, the court treated a stock purchase followed by a liquidation as an asset purchase for tax purposes, allowing the buyer to receive a cost basis in the acquired assets. Congress later codified and refined these concepts in Section 338, particularly in response to the repeal of the General Utilities doctrine by the Tax Reform Act of 1986, which had previously allowed corporations to distribute appreciated property without recognizing corporate-level gain.

Transaction Structure: Stock Purchase Versus Asset Purchase

In a typical acquisition, the parties must choose between a stock purchase and an asset purchase, each carrying distinct legal and tax consequences. In a stock purchase, the buyer acquires the shares of the target corporation, and the entity continues to own its assets and liabilities; the tax basis of those assets remains unchanged, and the buyer’s basis is in the stock itself. In contrast, an asset purchase involves the buyer acquiring individual assets, resulting in a stepped-up basis to fair market value, but often requiring renegotiation of contracts and triggering potential sales or transfer taxes.

The Section 338(h)(10) election bridges these two approaches. It enables the transaction to proceed as a stock purchase for legal purposes-thereby preserving contracts, licenses, and other legal relationships-while treating it as an asset purchase for tax purposes, allowing the buyer to step up the basis of the acquired assets.

Eligibility and Requirements for the Election

Not all transactions qualify for a Section 338(h)(10) election. The requirements are specific and strictly enforced. First, the buyer must be a corporation (either C or S) and must acquire at least 80% of the total voting power and value of the target’s stock within a 12-month acquisition period, as defined by 26 U.S.C. § 338(d)(3). Second, the seller must be either the parent of a consolidated group, an affiliate, or all shareholders of an S corporation. Third, the election must be made jointly by the buyer and all eligible sellers, which, in the case of an S corporation, means every shareholder must participate, regardless of whether they sold their shares. Failure to meet any of these requirements precludes the use of the election (Treas. Reg. § 1.338(h)(10)-1(c)).

Mechanics and Tax Consequences of the Election

When a Section 338(h)(10) election is made, the transaction is deemed, for federal tax purposes, to proceed as follows: the target corporation is treated as if it sold all of its assets at fair market value to a new corporation (often referred to as “New Target”) on the day after the acquisition date. Immediately after, the target is deemed to liquidate, distributing the proceeds to its shareholders or parent entity. The buyer’s new subsidiary receives a stepped-up basis in the assets, calculated under Section 1060 and the applicable Treasury regulations. The gain or loss from the deemed asset sale is reported on the target’s final tax return, and, for S corporations, this gain flows through to the shareholders and is taxed at the individual level (26 U.S.C. § 338(a); Treas. Reg. § 1.338(h)(10)-1(d)).

For the buyer, the primary benefit is the ability to depreciate or amortize the stepped-up basis in the assets, creating future tax savings. For the seller, however, the deemed asset sale can result in higher taxes, especially due to depreciation recapture and the loss of capital gains treatment on certain assets. Sellers often negotiate for a higher purchase price or a “gross-up” to offset this increased tax liability.

Procedural Requirements and Compliance

The Section 338(h)(10) election must be made on IRS Form 8023, “Elections Under Section 338 for Corporations Making Qualified Stock Purchases.” The form must be filed no later than the 15th day of the ninth month after the month in which the acquisition date occurs, as mandated by 26 U.S.C. § 338(h)(10)(D) and Treas. Reg. § 1.338(h)(10)-1(c). Additionally, the parties must file IRS Form 8883, “Asset Allocation Statement Under Section 338,” to report the allocation of the purchase price among the target’s assets. Failure to timely and properly file these forms, or to secure the participation of all required parties, can invalidate the election and result in the loss of the intended tax treatment.

Strategic Uses and Planning Considerations

The Section 338(h)(10) election is most advantageous in scenarios where the target’s value is largely attributable to goodwill or other intangibles, as the buyer can amortize this goodwill over 15 years under Section 197. It is also particularly useful in the acquisition of service firms or government contractors, where continuity of contracts and relationships is critical. In leveraged buyouts, the increased depreciation and amortization deductions can help offset income from debt-financed acquisitions.

However, the election is less attractive when the target has significant built-in gains in depreciable assets, leading to recapture taxed as ordinary income, or when the seller is unwilling to accept the higher tax burden without compensation. Additionally, the election can result in the loss or limitation of valuable tax attributes, such as net operating losses (NOLs) and tax credits, and state tax treatment may not always conform to federal rules, potentially resulting in additional sales or transfer taxes.

Risks, Limitations, and Anti-Abuse Provisions

While the Section 338(h)(10) election can provide substantial tax benefits, it also introduces complexity and risk. The regulations include consistency and anti-abuse rules to prevent selective basis step-ups and to ensure that all acquisitions from the target or its affiliates are treated consistently as either stock or asset purchases. The final regulations, as amended after the Tax Reform Act of 1986, have clarified and simplified these rules, reflecting Congress’s intent to balance legitimate planning opportunities with the prevention of abusive transactions (Treas. Reg. § 1.338-8).

Moreover, the election’s complexity requires careful planning, comprehensive due diligence, and clear communication among all parties. The loss of tax attributes and the potential for disparate state and federal tax treatment must be considered in structuring the transaction.

Example

Consider a scenario in which a corporation acquires 100% of the stock of an S corporation from two individual shareholders. If the parties jointly elect under Section 338(h)(10), the S corporation is deemed to sell all of its assets at fair market value, with the resulting gain allocated to the shareholders and taxed at their individual rates. The subsequent deemed liquidation is generally not taxable, as the shareholders’ basis in the stock equals the fair market value of the assets received. The buyer’s new subsidiary then holds the assets with a stepped-up basis, enabling enhanced depreciation and amortization deductions for future tax years (26 U.S.C. § 338(a); Treas. Reg. § 1.338(h)(10)-1(d)).

Section 338(h)(10) Versus Other Tax Elections

Section 338(h)(10) is distinct from other tax elections, such as the Section 338(g) election, which can be made unilaterally by the buyer and generally applies to foreign targets or sellers not eligible for a Section 338(h)(10) election. The Section 338(g) election typically results in two levels of tax for C corporations-one at the corporate level and another at the shareholder level. Section 336(e) provides a similar asset sale treatment for certain non-corporate buyers but has different requirements and consequences. Understanding the distinctions among these elections is crucial for optimal transaction structuring.

Best Practices for Implementation

Given the complexity and high stakes involved, parties considering a Section 338(h)(10) election should engage experienced tax and legal advisors early in the process. Comprehensive due diligence should be conducted to evaluate the target’s asset basis, built-in gains, and potential loss of tax attributes. All shareholders or parent entities must be informed and consent to the election, and state tax implications should be carefully reviewed. Meticulous documentation of the transaction, the election, and all related filings is essential to support the intended tax treatment in the event of an IRS audit.

Section 338(h)(10) of the Internal Revenue Code is a sophisticated and versatile tool in the realm of M&A tax planning. By allowing certain stock acquisitions to be treated as asset purchases for tax purposes, it offers buyers the benefit of a stepped-up basis in acquired assets and the associated tax savings, while imposing additional tax burdens on sellers. The election’s statutory basis is found at 26 U.S.C. § 338(h)(10), and its application is shaped by Treasury regulations and case law such as Kimbell-Diamond Milling Co. v. Commissioner, 14 T.C. 74 (1950), aff’d, 187 F.2d 718 (5th Cir. 1951). Proper use of the election requires careful planning, strict compliance with procedural requirements, and a thorough understanding of the tax consequences for all parties involved. When implemented thoughtfully, the Section 338(h)(10) election remains an invaluable instrument for achieving tax efficiency and flexibility in corporate acquisitions.

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